Wednesday, July 30, 2008

This link will find you an English Language version of the Memorandum of Understanding (MOU) on how the Swedish, Latvian, Estonian and Lithuanian central banks will work together to solve a financial crisis.

The MOU is a exercise in deliberage vagueness in the mould of central bankers almost everywhere.

I was discussing yesterday's post with a hedge fund manager (HFM) who gives that useful (and false) impression of being not too bright.

I starting explaining the Swedbank thing to him. You could tell he was only half listening.

Until I got to the statistics for Latvia. His ears pricked up when I said the current account deficit was well over 20 percent of GDP.

HFM: "Who are they stealing that from?"

BC: "Swedbank"

HFM: "So why didn't you say so?"

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Well there is a reason that I didn't say so - which is that you wouldn't believe me if I posted the short hand. But what a 2o percent current account deficit means is that the AVERAGE PERSON spends 20% more than they earn.

This is of course impossible unless they are not going to repay it.

Borrowing without intention or ability to repay is the economic (but not moral) equivalent of stealing... and it doesn't matter what currency that borrowing is in...

This "theft" is so large that Swedbank is nearly insolvent.

And Swedbank management are steadfast in their belief that nothing is fundamentally wrong. Well they would say that, wouldn't they...

As expected yesterday’s post drew more reaction (and visitors) than any previous post on this blog.There are a few corrections to make (mostly minor).But I should also share with my readers a taste of the comments that came through the mail.

The only really substantive comment – which came both on the blog and through the mail – was that I underestimated the importance of lending in Euro (rather than Lats) in Latvia (and presumably the other Baltic states).

That is fair enough.Consumers can have a high price loan in Lats or a low price loan in Euro.They take the low price loan in Euro.

However if the currency suddenly halves a lot of distressed borrowers (and I will prove over the next few days that they are distressed) will suddenly owe twice as much as they previously owed.Hansa Bank will then implode in credit risk.Credit risk, currency risk – you pick your poison…

It all reminds me of a flight I was once on between Singapore and Sydney where I sat next to the regional head of credit for Citigroup.He was the perfect upper-mid-level executive – and would only talk about the distant past.However he pointed out that many risks that banks face are equivalent in extrema.For instance if you have lent to people in a currency where interest rates suddenly go to 50 percent (as happens in some devaluation crises), your funding cost (deposits) will rapidly go to 50%.However if you pass that on to your borrowers they will fail. You will suffer credit risk and possibly go insolvent.If however you have offered fixed loans to your borrowers you will wind up with huge funding mismatches – and possibly go insolvent.For small moves there is a difference between credit risk and interest rate risk.For large moves there is no effective difference. The same analysis applies to currency and credit risks.

The second set of comments came down to whether it was possible for Swedbank to go insolvent even if Hansa were a complete disaster.Swedbank has about 40 billion Swedish Kroner in Hansa (including both debt and equity stakes).Swedbank has tangible capital closer to 50 billion Swedish Kroner.If everything goes to zero (which it won’t) then Swedbank still has tangible equity they would argue.And Hansa – no matter what happens – will get some recoveries.

That may be right.Swedbank will look considerably worse than Washington Mutual does now but it may be solvent.Indeed WaMu has blown up considerably less capital than Swedbank does under any variant of that model.But then I think WaMu is solvent.(Regular readers know I own the subordinated debt.)

I used to think – and I made it clear in the post – that Swedbank probably survived.After their conference call and the lack of indication that they will ever pull the plug – I now think they probably fold.However if they pulled the plug now and were straightforward with the risks they were taking the stock would almost certainly stay above zero.[Memo to Swedbank management – now is your time.]

Thirdly there was some objection to my characterisation of the Latvian economy as being driven by sex tourism.Thailand would have a similar objection.But there was a more politically correct way of saying it.One reader wrote:

“A pint of lager costs the same in Tallin as it does in Mayfair, despite earnings power being 4-10x higher in the latter.”

You could argue similar about property prices...

Some noted that I got the currency crises confused when I talked about the fall in the Thai Baht.I did.The Thai Baht only fell by about 60%.The Rupiah fell something between 80 and 90.I never traded anything in Thailand – but I did buy HM Sampoerna near the base of the currency crisis in Indonesia – so I remembered the good side of this (buying really cheap assets). The exact fall is a detail lost in my memory. And I wish all my stocks could be Sampoernas...

Several noted that there was little new in my post.One sell side stock analyst from Scandinavia said that there was nothing new in my post – quibbled about minor errors – and said that it was what he believed but he wasn’t allowed to be so blunt.Several pointed out that the uber-bear Roubini has been saying the same thing.He has – albeit less with less colour!

There were several comments from people who had lived through the Argentine crisis who thought that I had the character of crises spot on.There were a few people from the Baltic republics who didn’t feel it was inaccurate though quibbled about minor details.

Some people noted that the biggest risk to a short position was the geo-political significance of the Baltic States.Simple question: if there is a crisis do you think Putin will take advantage?

And that I think is the real reason this situation is allowed to go on.Nobody thinks the economy of the Baltics will collapse without Western bailout.They are watching the geopolitics.And maybe they are right.I don’t do politics very well.

But otherwise enjoy a post that breaks all the rules. I am loudly calling the likely collapse of a politically sensitive country. Its one of those circumstances when shouting fire can cause the tragedy. To some extent I take comfort in my low readership.

I promised when I started this blog to have a global focus. I haven’t mostly because the most interesting story around is what is happening in the US financial market. But I hope to remedy that in this post as I give you, dear readers, a financial tour of Sweden, Latvia, Estonia and Lithuania.

I shouldn’t shout this story – but it is such a good story I can’t resist. The title is a little sensational too – but not unfair.

Before I start I need to introduce you to a model of bank collapse.

The fixed currency model of bank collapse

First observation: banks intermediate the current account deficit

·Countries that run big current account deficits have banks with loan to deposit ratios above 130. (See Australia or New Zealand for examples.)

·Countries that run big current account surpluses have loan to deposit ratios of 70 or less. (See my post on 77 Bank for an example.)

·Another way of saying this is that banks in current account deficit countries are generally reliant on wholesale funding. [It’s the crisis in wholesale funding that is causing the problems in American banks now.]

Second observation: fixed exchange collapse with currency runs

When a country has a fixed exchange rate that is too high (evidenced by unsustainable current account deficits) they become subject to runs on the currency. This happens as follows:

·Some speculator (eg George Soros) shorts-sells the currency and buys whatever it is fixed to. They do this by borrowing the target currency or by withdrawing lending in the target currency.

·They then take the borrowed currency and give it to the central bank/currency board who swap the domestic currency for foreign reserves at the fixed exchange rates. In doing so they reduce domestic money supply causing short term interest rates to rise. If they do this enough they induce a recession (ugly). This creates pressure (political and otherwise) for a deviation.

·Alternatively the central banks sterilises the money supply change. However if they continue to do this they will run out of foreign currency reserves – and the fixed exchange rate collapses anyway.

Many a fixed currency has been broken this way. George Soros did it with the pound. Nameless speculators did it across Asia. The Mexican Peso and Argentine Peso both had fixed currency pegs that didn’t hold.

Third observation: a currency run results in the banks being de-funded.

·Given that most the lending in the “target currency” is to banks and the banks in current account deficit countries are generally dependent on wholesale funds – the run on the country causes funding pressure to banks.

·This funding pressure when it is particularly intense will cause those institutions most dependent on foreign currency to become illiquid and hence collapse. The currency crisis morphs into a run on bank wholesale funding.

Past currency crises have been associated with bank collapses. In Thailand (which was precisely to this model) the finance companies actually collapsed and the banks almost collapsed. In Korea both the banks and currency collapsed.

But you need to be really careful of countries with fixed exchange rates and huge, unsustainable current account deficits.

Never much fun shorting the banks in such countries

If you had picked the collapse of the Thai Banks you might have cleverly shorted the stocks. It would not have helped much. Suppose you shorted $100 worth of a Thai bank. It collapsed down 95% (corrections in the comments). So you had $95 in profit. The only problem is that you have the profit in the pre-crisis exchange rate. The currency also dropped almost 90%. So you were left with about $10 profit. That is fine-and-dandy but it is not much reward for effort of picking a system that is about to collapse.

You would of course be much better just shorting the currency – or shorting the ADRs of the target stock (the ADRs being priced in a hard currency).

The real exception is that if you find a bank in a hard currency that is totally exposed to the debacle country you can make a fortune. You can guess now that Swedbank is my bank. It is not the only one – but is very spectacular.

Current account deficits, fixed exchange rates and Eastern Europe

Eastern Europe is full of vulnerable currencies. Most of the countries have fixed their exchange rate to the Euro (hoping I guess for Euro membership at some stage) and have massive current account deficits.

Latvia is particularly bad. The exchange rate is pegged (as per this page from the central bank of Latvia). The current account is enormous, almost 25% of GDP. There is no doubt whatsoever this exchange rate is not sustainable. Not close.

As the Latvia economy watch blog will point out Latvia is suffering the results of the beginnings of the credit crisis caused by fixed exchange rates and a run on the capital account.

Estonia is not much better. It too has a large current account deficit and its currency (the Kroon) is also fixed to the Euro.

Lithuania is a little better – maybe only marginally more unsustainable than the United States.

Manifestations of the Baltic madness

Argentina in the days of the fixed peso was a party for the middle class. The middle was the main beneficiary of the fixed currency – and when it was over the middle class rioted.

A similar party is visible in the streets of Riga. Mercedes are everywhere. Bentley has opened a dealership. However this ignores my favourite take on Riga. It’s the rise and fall of the bucks parties…

When travel to Latvia opened up it was eye-popping for an awful lot of British lads. Here was a country where the women were Baltic Beauties – and poor. To the London lads this was bucks party heaven. It became more so when Ryan Air put on a Friday evening flight from London to Riga. Ryan Air even tried a Riga-Shannon route to service the Irish lads. The locals even got to classifying all Brits as Ryanair sex tourists as this club review shows.

Well due the crazy exchange rate the bucks parties got too expensive. I am not going to lead your round the internet to stories about over-priced hookers – but the bucks parties are moving to Prague. The Shannon-Riga flight has been cancelled. Ryan Air has recently announced a Friday night Birmingham to Prague flight.

Manifestations of the Baltic Madness in bank balance sheets

The largest Baltic bank is Hansabank – a wholly owned subsidiary of Swedbank. The last Swedbank annual report contains this fascinating summary table:

For the currency challenged – there are about 6 Swedish Kroner to the USD.

The deposits are 102 billion kroner, loans 177 billion. That is a loan to deposit ratio of 174%. That would be pretty high for a country – but it turns out that Swedbank (via Hansa) gets 177% by having a massive deposit share – as seen in the following table:

In Lithuania the loan to deposit ratio looks sensible. In Estonia – despite a 62% deposit share and only a 49% lending share the loan deposit ratio is 163 percent. In Latvia the loan deposit ratio is a 176%.

The observant amongst you might have noticed that the loan to deposit ratio in the two tables doesn’t match. I can’t work out why either…

Whatever Hansa Bank is very wholesale funded. This can be seen in Hansa’s balance sheet (from the English Language version of Hansa’s annual report).

Again for the currency challenged there are 0.45 Lati to the USD.

The key observation here is that deposits are 1.7 billion Lati and loans are 4.2 billion. The loan to deposit ratio is 244 percent.

Again the observant will notice that this ratio is different to Swedbank’s annual report – suggesting that when talking to analysts Swedbank seems to think that a lot of wholesale funding in Latvia is deposits. Other than that (cynical) line I have no explanation.

The main source of funding is in the line: due to financial institutions. There is 2.7 billion Lati due to financial institutions.

Fortunately Hansa Bank tells us more about that. Here is a table from the Hansabank annual report about the money due to financial institutions…

So now we can see it. Swedbank funds the Latvian current account deficit. It funds it in Euro.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn’t devalue its only because people (ie Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can’t be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank’s equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can’t print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

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I wrote this post before SwedBank's great looking 2Q results. They made it all work - by lending even more to the Baltics. Latvian deposits are actually falling despite high inflation and rapid (but declining) loan growth.

I used to think Swedbank would probably survive. I now think it probably goes to zero.

GE finance arm says 2 units are being examined over marketing, sales of financial instruments HARTFORD, Conn. (AP) -- The finance arm of General Electric Co. says two units are being investigated in connection with an industrywide probe into marketing and sales of guaranteed investment contracts and other financial instruments to municipalities.

In a filing Friday with the U.S. Securities and Exchange Commission, General Electric Capital Corp. said GE Funding CMS and GE Funding Capital Market Services Inc. have been subpoenaed for information.

GE Funding Capital Market Services has received notice that the SEC staff may recommend that the agency bring a civil injunction or begin an administrative proceeding in connection with the bidding for financial instruments associated with municipal securities by former employees of GE Funding Capital Market Services.

General Electric Capital said it is cooperating with the SEC and antitrust division of the Department of Justice.

As regular readers know I now am the proud owner of a (scary) position in WaMu subordinated debt. The reasons were explained here.

It is clear that the market disagrees with me. Here is a chart of the credit default swap. Its right up in Ford Motor territory...

I have had one reader disagreeing with my analysis and suggesting that WaMu losses could be $60 billion. They have not explained their estimate - so it doesn't help me much. The market is inherently estimating that 60 billion is possible.

60B strikes me as inherently implausible - but this blog exists so that the diaspora can point out my mistakes. I like being told why I am wrong.

So please - suggestions and quantifications devoutly desired.

Minor update and correction: The Series K is floating rate - but the floating rate is based on the $25 base. The series K is trading at a very small proportion of face. My calculations as to running yield are slightly (but only slightly) wrong. Thanks to a reader for this correction. I also own the series R which is a 7.75% fixed and I confused the coupons. I was more interested in the K (which is cheaper) essentially betting on solvency rather than current coupons... The R is convertible - but I am not that much interested in the conversion. Par is all I hope for...

Monday, July 28, 2008

The ABX credit data is showing that the rate of increase of 60+ delinquency for 2006 mortgages is clearly slowing. It has been doing so for several months. The worse the pool of mortgages the faster the improvement.

This is also true of other mortgage pools I am looking at – though some 2007 pools are continuing to deteriorate.

Companies that wrote lots of their business in 2006 might now be seeing light at the end of the tunnel.For companies that wrote lots of business in 2007 that light might be an oncoming train.

This is relevant to the underlying books of the bond insurers and others.

I am wondering whether this trend applies to mortgages generally - as some bond insurers stopped writing earlier than others - and some mortgage insurers ramped up their business in 2007 to take advantage of the "opportunities" as competitors left the market.

If anyone has been looking at this sort of data in detail - I would love you to share it with me.

The Dell Blog I refer to in this post has now been deleted. The reason for the deletion is that I got a phone call from the Australian consumer regulators which pointed out a specific legislative provision that Dell had structured its terms to get into. The post is wrong in law. Law is not my usual thing. Sorry.

Michael Dell has gone back to Dell to solve its problems.The problems are usually described as customer service but that the techs I asked pointed me to faulty equipment being produced and customer service problems are really customers with faulty product overwhelm the system.

"The Apple model" – make sure it works simply and easily – and then you hardly need customer service. You will wind up with a deserved reputation as the "consumer company"

'The Dell model" – make it cheap and sloppy and sell overpriced warranties because the customer will need them.

Anyway I spent a whole lot of time looking at Dell stock – and then the Dell problem fell in my lap.I wound up in the customer service vortex – and it was caused by a computer with technically inadequate cooling.

The computer is faulty.The fault is described in no less a source than Wikipedia as the design fault with my computer.

Dell attempted to extort (illegal) warranty fees out of me.The fees are illegal because Australia has a statutory warranty requirement which makes the “Dell Model” as described above illegal.

Anyway – rather than spend more time researching Dell stock – I am conducting a social experiment in analysing Dell.I am going to sue them for breach of Australian statutory warranty – for the faulty equipment that they are knowingly selling.

It’s a small-claims process so it will probably take only three hours of my time.And I don’t have to go very far out of my way – I can file in the local court which is – would you believe – in Bronte Road.

As most of this is going to wind up being computer-technical (and not of much interest to my general readers) I have started another blog.

I will report back on this blog only on the basis that the results have investment implications.

Saturday, July 26, 2008

I might start a hedge fund one day.So maybe I shouldn’t spend my time tearing into funds-of-funds.

But I got a problem.I get a kick out of pulling wings off butterflies.

One of my earliest posts (and still in the top five accessed on this site) was a post about New World Capital Management – a fraudulent hedge fund in Santa Fe.The fund was a blatant and obvious fraud.

My first email from New World was 17 Jan 2008 – and I smelt a rat immediately.

But obviously not everyone did.Here is a fund-of-funds suing New World Capital Management and Greg Duran. This fund was still promoting New World several weeks after I smelt a rat.

This fills me with amazement.There is only one real reason for investing in a fund of hedge funds – and that is that the fund-of-funds do the due diligence for you.If a fund-of-funds got suckered by something as simple as New World Capital Management then they got no right to be in the business.And their clients should all pull their money now.Go on.Do it now.You should.

So with wonder and amazement I link you (again) to a small court case.It’s the fund of funds (not the management company) suing. It’s only for 750 thousand dollars but you would think the management company would wear it.

Let us review what these people are saying:

We are a fund of hedge funds.

We invest your money with frauds.

We can’t do our job.

Invest with us.

John

PS.Now if any funds of hedge fund want more simple due diligence – I have an email.Just contact.

Friday, July 25, 2008

Dell has a terrible reputation for customer performance – and that reputation has been the biggest driver of the stock price. Jeff Matthews has blogged about it here.

The big Kahuna (Dell himself) came back to Dell to fix quality – and presumably warranty and customer service issues.

I can assure you that the customer service fix has not reached Australia.I have a problem with an XPS1330.It’s a cooling problem – and I admit I probably triggered it by lying in bed with a laptop working.I guess that is what a laptop is for – but the machine got too hot.The motherboard fried around the video card.

Dell is a favourite amongst value investors.And maybe it will be a great stock if the service issues turn properly.

And I know that this is just an anecdote – but when I have to approach the Australian Consumer Commission to enforce my repair rights for equipment sold knowingly faulty I suspect there is a fair way to go.

However this is not the Dick Bove I want to talk about.Dick Bove gave an interview on Fox Business which is well worth a watch.Go on - watch it. In it he decries the bear case for banks.In particular he notes:

In 1990 when the troubles were occurring with banks non performing assets (NPAs) were about 5% of the industry when it is now about 3%.

He looked at NPAs compared to bank capital – and noted it was about 40% during the last crisis (a danger zone) and he notes it is now at 17%.

He thinks that big banks (like Bank of America) consist of more than their construction portfolio and their home equity loan portfolio.He notes that net interest income is going up.They are also a huge money management firm, huge data processing firm etc and these are all doing OK.

He is very annoyed at what the government is doing to smaller thrifts:

Government officials have said that they will allow banks to fail – and they have said many banks will go under – but they seem to save the larger banks.

It thus makes people move to Bank of America, JP Morgaan, Wells Fargo etc at the cost of smaller banks.

Anyway it is obvious that bank bad loans in American banks are nothing like as high as in the early 1990s.There is plenty of bad credit out there – but it is mostly not in American banks.In my history of the US Financial Market I wrote early last year I indicated that I thought the credit risk was in the securitisation market and mortgage insurers and by-and-large not in the (US) banks – and funnily enough that is what is happening – the huge losses realised by banks notwithstanding.[I underestimated bank credit problems – but that does not change the fact that the problems outside the US banks are much worse than the problems inside American banks.The credit problems at Natixis and UBS dwarf anything in America except maybe Citigroup.]

Moreover when I start trying to bash up banks there are many I can’t make them go bust including banks trading at 0.6 of book and where their subordinated debt is trading very distressed.One example: I think Fifth Third Bank is fairly clearly solvent – and the pricing of the equity and (particularly) the debt indicate that the market at least thinks insolvency is a realistic possibility. [Often the debt is a better buy than the equity – though as Bill Gross will point out in this video anyone who has purchased debt-like bank equity instruments is not very happy with themselves…]

I will assert that trading unrealistically depressed for the subordinated debt is commonplace.Even the (very problematic) Washington Mutual is probably solvent – though its biggest problem – which I think makes the stock unable to be owned – is the death-spiral financing it took with TPG.[TPG have an anti-dilution clause which makes raising any additional equity outrageously expensive.]

The Dick Bove problem

Let me phrase the Dick Bove problem this way: if bank credit is substantially better than the last cycle (even if non-bank credit is appalling) then why do the banks look so toxic?

Dick Bove asserts that they are just not so toxic.He made that call a couple of months ago – and anyone that followed his advice has been smashed.I will give him credit though – he has stuck to his guns.

I have another take.

My answer to Dick Bove

My answer to Dick Bove is as follows: despite all appearances to the contrary this is not a credit driven crisis.It’s a funding driven crisis.It is much worse than last time not because the losses are worse than last time (they are the for the whole system but they are not for the banks).It is worse than last time because the funding situation is diabolical.

What has happened is that American banks and investment banks have sold lots of toxic waste to Europeans and Asians and their credibility – both individually and collectively is impaired.The same banks have to sell their own debt and subordinated equity to the same Europeans and Asians that they ripped off only two year ago.To put it mildly that makes it harder for banks to fund themselves.

It’s the lack of credibility that is the major problem for many financial institutions.

Washington Mutual as an extreme example

Washington Mutual sold dross to the market.Mish follows a particularly bad WaMu deal.This deal is really toxic.WaMu simply didn’t care what it originated if it originated stuff like this.It didn’t care because it sold the risk.WaMu was in the business of ripping off the people funding its mortgage originations.

But what is left in WaMu is not actually that awful.I am not saying WaMu is pristine.That would be stupid.WaMu is a mess – but you need to make some pretty extreme assumptions to model it as insolvent.It has just over 20 billion dollars of tangible capital left (admittedly after a huge raise).It has 240 billion of loans with 8.5 of provisions already against them.It makes about 8 billion a year in pre-provision income and the net interest margin is rising as are low cost deposit volumes.

If you assume that WaMu takes 30 billion in cash losses on the loans (mostly mortgages) over the next two years it should be survivable.The pre-provision profit will cover 16 – the provisions another 8 and the capital ratio starts in the 7s.Tangible capital of 20ish would drop to 16 less any new provisions – and given the capital ratios at the moment would wind up at say 5.It would be difficult for management – but solvency should be OK.At 30 billion in cash losses the stock is probably OK long term provided the losses can be stretched out and WaMu is not forced into a capital raising.If the losses are closer to 10-15 billion the stock would be a big winner.

30 billion in losses is a number way larger than guidance or indicated in the delinquency.However nobody (including myself) believes WaMu because their credibility is stuffed.Remind yourself again about Mish’s bad deal.

The internet is full of stories about WaMu being insolvent – and those stories are credible precisely because WaMu has no credibility.

If WaMu were to take 45 billion of cash losses over four years the subordinated debt (trading just over 30%) should wind up worth par.[The stock of course would be awful.]It is not plausible to me that the cash losses on the portfolio will be that high.

The problem for WaMu is that they need to take their hit over three years.If they took it all at once WaMu would hit the wall very hard.They need to maintain their funding continuously to remain liquid.

Funding is a real problem (actually the problem) for WaMu.WaMu has net loans of 231 billion and a bundle of other assets.The core funding is deposits of 182 billion.There is a bunch of FHLB funding (secured) adding up to most the difference – but there are also “other borrowings” of 30 billion.

How much credibility does WaMu have to support those “other borrowings”?Short answer: not much.And if you look you will see the “other borrowings” are falling quarter by quarter reflecting the real problems that WaMu has maintaining those borrowings.WaMu has no choice but to shrink its way out of the “other borrowings”.

The very fine women who run Gimme Credit (possibly the best and most savvy independent credit analysis firm) have note that unsecured creditors are “pulling funds” from WaMu.They don’t want to use the phrase “run on the bank” – but it is probably a “walk on the bank”.

The difficulty maintaining wholesale funding is not caused by current balance sheet problems.(They are just not that bad.)The problem is caused by WaMu’s lack of credibility.If WaMu hadn’t sold a whole lot of toxic dross marketed as AAA the capital markets might trust them.

Cost of not being believed

The cost of not being believed as a financial institution is high.

Washington Mutual says that it has no need to raise capital – but the cynics argue that the truth is that they can’t raise capital.Certainly when the preferred shares yield 24% and they have an anti-dilution clause on the common –any capital raised would be enormously expensive.

I don’t think they need regulatory capital at the moment (see the calculation above).But the amount of capital you need is not a regulatory function – you need capital if the financial markets won’t lend to you.Capital gives you credibility – and because WaMu has no credibility it needs considerably more capital than its regulatory standard or its unsecured creditors will “walk”.So hang the regulatory standard – WaMu is short capital because it is short credibility.

If WaMu shortage of credibility (capital) turns into a liquidity crisis they will need to sell the whole shebang.Anyone say Wells Fargo, $1 per share?

If you don’t believe me think of Bear Stearns.There is a lot of dross around (most visibly the Vanity Fair article) which argues shorts bought down Bear Stearns.

I argue otherwise:Ambac insured a Bear Stearns home equity line of credit deal where Ambac has already provisioned over 80% of outstandings.Almost every loan made in that deal will default.

Bear told people things about that deal to get it sold and to get Ambac to write the insurance.Those things were lies, pure unadulterated lies.

If you tell lies for too long nobody will believe you any more and you will not be able to roll your own funding.And as a financial institution if you can’t roll your own funding you are going down.

It is entirely possible that Bear Stearns had adequate capital and inadequate funding (though I express no opinion).But the story that shorts told lies that bought down bear doesn’t hold water.Bear told the lies that bought down Bear.The fault resides totally with Bear’s management.

An investment idea

I have no strong opinion on whether you should be long Washington Mutual common or not.I think the problem with being long the common is the death spiral equity (with the non-dilute clause) that WaMu sold TPG is probably enough to decide against the common.Besides if the “walk on the bank continues” WaMu will need to sell itself in distress. The common is very cheap and very dangerous.

But if this is a credibility crisis and not a solvency crisis – and I can’t count it any other way – then the WaMu subordinated debt should be money good.There is a preferred instrument (the K class preferred) which is trading in the 6s against a face value of 25 – implying almost a three quarter chance of insolvency.

If – like me – you think that is overblown – then this is a buy.

You will lose 100% if WaMu if there is an FDIC takeover of WaMu.But if WaMu sells itself at $1 per share to Wells Fargo (or similar) you make a triple or more as the instrument returns to near par.And if WaMu is solvent independently you also make a triple.Meanwhile – as it is a 7.25% yield on face – you get a 26.6% running yield on the current price.That is sweet enough for me.

I purchased quite a few – and despite the 10% fall in their price yesterday I am still showing a profit...

But I can’t say this is a low risk position – and – in the tradition of this blog – I am looking for people to tell me I am wrong.I need plausible arguments as to why WaMu is not only illiquid – but is not worth Wells Fargo rescuing at $1 a share.

I will publish decent arguments explaining why I am wrong if the senders want that.(I am the arbiter of decent here – but if the arguments make me worried about a position I will publish…)

Thanks in advance. This is another position that scares the s--t out of me...

John

PS. I retain only two positions that scare the c--p out of me. You dear readers know both of them.

Thursday, July 24, 2008

I have always been intrigued by what “risk control” really means in banking.I know a lot about banking – but the level of sophistication by which I would control most risks is the “smell test”.Does this seem sensible of itself (and it is not sensible just because everyone else is doing it).If I get it wrong how much does it hurt?All very much the way Warren Buffett claims to judge insurance risks.

But financial mathematics has an attraction.It brings an appearance of precision to some very imprecise arts.

But my test as to whether you really understand financial mathematics is whether you can meaningfully apply it to simple real world problems.If you can get maths to do that it is not wasted and can add something to your risk management.

So – in this line – think of this post as a second year university financial mathematics course without the maths.

David – the financial salesperson extrovert and his sports betting junkie

David (not his real name) was financial sales guy I knew kind of well.Like most financial sales guys he was an extrovert.He worked with analysts – and they were all introverts.If you put him in a bus with his colleagues on the way back from some Christmas function he would try to get everyone singing Scottish football songs.This was amusing but usually unsuccessful.To the extent it was successful I blame alcohol and not David’s out-of-tune lead.[Dave – if you are reading this – your singing wasn’t bad – it was just memorable.]

Anyway Dave had fifty bucks left in an old sports betting account.He reckoned that he could bet the entire sum every week for six months and end up with more money than he started with.

This sounded impossible – and I was prepared to fund the experiment if I was wrong.

David may have been a sales guy – but he was no fool.He divided his stake into five equal amounts and bet on five near certainties.A typical sort of bet might be for Roger Federer to win the second round at Wimbledon. Like a good sales guy and sports fanatic he could find five such events somewhere in the world most weeks.

He wouldn’t get great odds – the bets often paid only 1.05 times the sum wagered.But he would win all five bets most weeks.

The odd week he would lose one – and the four winners would wind up losing 16% (=1-4*1.05/5).It would take him a few weeks to recover – but he recovered – and little harm was done.

I lost track of how David was going – but you can see what is going to happen.Week in, week out the David will make a profit.He might have a setback – but it would be manageable.He looked like a consistent winner.

Of course if he did it for long enough his number would be up – and he would bet on five losers.It is highly unlikely to happen in any particular week – but done for long enough it was inevitable.

The strategy will have the property of making regular seemingly-consistent profits – but taking irregular large losses.Off six months of data it was almost impossible to tell if he was adding value with his wagering – but my guess is he probably wasn’t.

So what has this got to do with financial mathematics?

Well what David was doing was betting on likely outcomes.If you bet on likely outcomes you make money most the time but when you lose you lose big.

I call this selling volatility in the sports betting market.You can model it just like selling volatility in the finance market (but hey – I am saving you doing a financial maths course).

Selling volatility in financial markets is just betting on the world staying within likely parameters.I can design you a hedge fund that would make a profit almost all the time –and has fantastic consistent returns.

Maybe I could even convince rating agencies I am a genius.But the only strategies I know that are consistent have a blow-up risk.That is what selling volatility is all about.I know several Australian funds (and there were many more) which blew up precisely this way late last year.

If you watch for long enough it is amazing how often you see people selling volatility.And they often don’t even know they are doing it.Over times I hope to point a few out.But that is subject matter for later posts.

Wednesday, July 23, 2008

In my first post on Fifth Third I noted that Cincinnati Financial (a well run insurance company) had a massive holding in 53 during its great run up. They retained the holding as the stock fell from $60 to $10.

Guess what - they sold half today - and the explanation makes no sense. They want to reduce their exposure to low-dividend stocks.

What is remarkable about the sale is that they are selling 480 million in stock after the price collapse - and they still have to pay 120 million in capital gains tax. That is reflective of how good a stock 53 was before it became bad...

And having to pay 120 million in capital gains tax is a high quality problem - but it would have been a higher quality problem to have paid 600 million in tax a few years ago!

Tokio Marine is a shockingly overcapitalised Japanese insurer.It consists of a vast excess of Japanese bonds and equities writing a fair bit of profitable Japanese business and some not so profitable business whenever it leaves Japan.(In that light it is oh-so-typical Japanese.)

Philly is one of the best run companies I have ever seen.It has family ownership and control – with an old guy with too many heirs.It is a better risk selector than any in the business – and (despite a little bit of legerdemain with reinsurance) has generally written extraordinarily profitably.[For those with a memory – the legerdemain had to do with their Katrina losses.Herb Greenberg wrote about it…]

I have at various times been short the stock (and consistently lost money).This was not a management short – just a valuation story.Philly wrote at a combined ratio of 80 or so - in other words unsustainably well.And despite that it traded at one of the highest multiples in the industry.If they even reverted slightly towards normal the stock probably would have halved.

I am (thankfully) not short it now (plenty of other fish-to-fry).But you got to admire the family getting out now and finding a buyer.

Insurance rates are falling continuously – and so it is almost inevitable that they will not continue to underwrite at such super-profitable ratios. The right valation is probably $20 a share - not the $61 being paid...

Second lesson:The Japanese are willing to pay big prices for non-problematic businesses and reasonable prices for problematic ones.We should not be surprised at the big Japanese banks injecting capital into the highly problematic Barclays.

There will eventually be a Japanese exit for many American financials.Maybe the Japs will be tempted by the weak USD.

Warning

I have never noticed these Japanese financials being particularly well managed – but they are wealthy – and in the acquisition battle wealth beats smarts – at least for the next couple of years.

I would be far more excited if a Japanese insurer were to buy back 400 billion yen of one of its own shares… but hope doesn’t help you pick stocks.

Tuesday, July 22, 2008

Yesterday I noted that Ambac’s paid claims are running about 20 million a month – which is somewhat less than the 150 million a month that say MGIC is paying. I also noted that their claims paying capacity was a fair multiple of MGIC.

I didn’t include the real big Ambac problem. They insured a whole lot of CDO exposures which are currently non-defaulted but whose credit profile is deteriorating and on which the end losses will be large but are uncertain.

Here is what I refer to as the oops slide from Ambac’s last fixed income presentation. It breaks up the CDO exposure by original rating and Ambac’s current (self estimated) rating:

This slide alone explains why Ambac is so much more damaged than MBIA. It’s the reason why I might be mad with my Ambac holding.

Nothing much else in Ambac’s insurance company alarms me… but this is petrifying.

If someone has some granularity on the deals – both likely default rate and likely loss given default I would love to see it.

There is no standard definition of subprime.I used to think of the world in terms of “Household International Subprime” and “Conseco Financial Subprime”.The guys at Household didn’t think you could ever write loans at the Conseco level profitably over a cycle (discussion in year 2000).The HI credit modellers I talked to were well aware of the risks of the business – but thought it was unlikely that there would be severe stress on it outside periods of large unemployment.(They were wrong!)

Nonetheless the year 2000 distinction between Household and Conseco could be given with FICO scores:

·Household Subprime was FICO620 to 680, and

·Conseco subprime was below 620.

I think the guys at HI were more-or-less right.The HI business might be profitable on average over long periods and the Conseco business was hopeless at the outset.[Profitable over long periods does not make it a good business.]

After that conversation the world changed and everyone started doing Conseco subprime.There were plenty of issuers who worked with FICOs of 575 and below.I was short several – not because I thought a blow-up was inevitable –just that that sort of business cannot be profitable over a cycle.

High FICO defaults – or why FICOs were misleading

FICOs have proved not to be a great indicator of default.

There are deals done with a weighted average FICO of 710 which are defaulting very badly – see the FICO in Mish’s bad deal for instance.These deals consisted almost entirely of refinances – often cash-out refinances.A person with very poor credit could show as having good credit if they always repaid their last loan.They can achieve this by sequential cash-out-refinances.(A rolling loan gathers no loss.)

Deals with average FICOs above 700 that are behaving that way usually contain a very large number of cash-out-refis.

Why I mention

One of my games is to look at the definition of subprime that people were using (particularly prior to the recent credit crisis).Lots of companies wanted to deny they did subprime loans – so all they did was define subprime to be a credit notch below where they were.Defining the loan as Alt-A doesn’t make the bad credit go away – but it made you look safe.[See IndyMac for a company that denied doing bad credit by defining good as what they did.]

Anyway here are two definitions that stand out for me.The first is from MGIC – a mortgage insurer.The second from Ambac.

Here is MGIC’s definition (2006 annual report):

A-minus and subprime credit loans are written through the bulk channel.A-minus loans have FICO scores of 575-619, as reported to MGIC at the time a commitment to insure is issued, and subprime loans have FICO scores of less than 575.[MGIC defined prime loans as having a FICO above 620.]

To me this definition was astounding.The whole of Households year 2000 business would be prime by MGIC’s definition.

Ambac drank the poison too.It drank less poison but was less aware that it was doing it.The word FICO never appears in the 2006 annual which is full of soothing words about how they had reduced their underwritings in the subprime area.By the 2007 annual report they included a FICO definition:

FICO scores range from 300 to 850. Though there are no industry standard definitions, generally FICO scores are as follows: prime (FICO score over 710), mid-prime (FICO score between 640 and 710) and sub-prime (FICO score below 640).

The entire MGIC midprime business and some prime business is subprime by Ambac’s definition.

I knew in advance that MGIC’s underwriting standards were worse than Ambac.Much much worse. I was short MGIC and had sold out of Ambac. [I always wanted to be long Ambac as much as anything because I liked the CEO. I just did not like the credit cycle and some deals they were underwriting - so I sold my position well before the top.]

Ambac has many times the claims paying capacity of MGIC and a small fraction of the claims rate.

But MGIC is still writing business and Ambac has almost ceased.

They might both be bust – indeed I express no opinion about the insurance companies.But if MGIC remains solvent and Ambac fails then the world is a very strange place indeed.[I will explore MGIC in more detail in a future post.Suffice to say I have no position long or short and the world might indeed be strange.]

I have just sold my small holding of MBIA. I have been convinced - following a careful examination of documents issued for GICs - that this post is incorrect in several important ways. In particular the GICs at MBIA have a larger effect on parent company liquidity than GICs at Ambac.

I still have no opinion whatsoever on the solvency of the insurance company. [I intend to do that work - and if I form an opinion that is worth having then I will again take a position in the stock.] I now however take the view that if the insurance company is bad the parent company is likely bad.

And that the statement by Jay Brown about parent company liquidity in a recent letter to shareholders is actively misleading.

I have retained my holding in Ambac.

I make plenty of mistakes. This sort of mistake I enjoy. I made a profit.

But being wrong in the past won’t stop me trying to be right in the future.Besides it is worth considering what proportion of a bank’s margin comes from accepting interest rate risk, what portion comes from accepting credit risk and what portion comes from just servicing customers.

The current yield for interest rate risk

Currently you can buy an “on-the-run” Fannie Mae guaranteed 30 year fixed rate mortgage with a yield of 615bps.Before the Fannie Mae credit crisis it was still almost 600bps.Bloomberg gives a series of what the on-the-run mortgages yield – the so-called “perfect coupons”.You can find this sequence by typing MTGEFNCL on your Bloomberg – or just find a graph here.

Currently the intended Fed Funds rate is 200bps and (highly) secured borrowings will cost only (say) 50-100 bps more than Fed Funds.

Now if we presume that the Fannie Mae mortgage is guaranteed by the Federal Government (a good assumption after last week) and is hence riskless then you can earn approximately 300-350bps by taking only interest rate risk.All you do is borrow floating to buy “perfect coupons”.And you don’t hedge anything.

300bps levered 10 times and with 30% tax taken out will still give you a 20% post tax return on equity.

Unfortunately you take a shocking amount of interest rate risk to get that 20 percent return on equity.The mortgages will (at least in normal times) refinance if rates fall.They will however extend for an unknown but long period if rates rise.Pretty well all movements in interest rates are negative for someone taking that sort of interest rate risk.Indeed it is very easy to model insolvency for such a company.

It was my contention – wrong it seems – that the main risk taken by US banks was interest rate risk.You can see the gory details of my mistake here.

State of the banks

There are banks that take mostly interest rate risk and banks that take mostly credit risk.

Banks that take mostly interest rate risk tend to have floating funding and have assets that are either GSE securities or very secure mortgages.Extreme examples included Commerce Bancorp (something I was short on interest rate risk and lost), and New York Community Bancorp.[State Street also takes a surprising amount of interest rate risk whereas Bank of New York tends to prefer credit risk.]Banks that take mostly interest rate risk have had great relative performance.In the event of an inflationary spiral those same banks would under perform massively. [The jury is still out on inflation – another theme of this blog.]

Other banks however eschew almost all interest rate risk keeping their asset and liabilities of matched duration – which usually means keeping securities of short duration.If you took mostly credit risk and were reliant on wholesale funding your very existence is threatened at the moment.To some extent the way I am shorting now is to find smaller banks that were consciously rejecting interest rate risk two years ago – but still have fat margins.They had to have done something bad to maintain those fat margins…

Margins and risk

I mention all this for a reason.If you are earning more than 300-350bps of spread in a bank you are taking some funding or credit risk – because it is simply not possible to earn that in interest rate risk unless you own some very exotic instruments.

Contra: I know of one bank which issues callable funding to buy callable assets.This sounds like it is matched – but if rates go up the funding gets called and they lose (having to refinance at higher rates).The assets however stick around.If rates go down the assets get called – and the funding sticks around and they lose.This bank has held up remarkably well through the crisis because they don’t take many credit risks – even if they do take enormous interest rate risks.The bank could still wind up highly problematic but it won’t get that way on credit.

But short of such exotic behaviours if you are earning more than about 300-350bps you are taking credit risks.If you earn 350-400bps of spread and you specifically disavow interest rate risk then you are taking a very large amount of credit risk.Find me regional banks that rejected most interest rate risk two years ago and I will find you regional banks that are potential credit problems.

Hybrid banks

Most banks fall somewhere in the middle.To pick one of many examples, Webster Financial Corp is a bank which is pretty well run. It is headquartered in WaterburyConnecticut and its management are known to several Connecticut hedge fund types.

Webster made the same mistake as me.It thought that interest rate risk had to be avoided.So it reduced interest rate risk – quite sharply.It decided to take some (quite a small amount) of credit risk.You would call this risk diversification.The stock price shows the result.

Webster was early to recognise their mistake.As I said – they are pretty well run– and in the scheme of things they are hardly a bank that is likely to wind up owned by the Feds.But shareholders have hardly had a nice time.

Webster took mostly interest rate risk.This is its five year margin summary – which shows non-performers including real-estate owned reach the princely sum of 1 percent of assets (on their way quite a bit higher).

Note the interest rate spread was always below 350bps but still above 300bps.

That is very high by global standards because in most countries banks do not have huge refinanceable assets – and hence do not carry the sorts of interest rate risks that American banks take. Its a middling spread by American regional bank standards.

My regional bank

Last week I referred to a regional bank which I had been working on with a reader.Small cap – so we won’t mention its name.I wanted to short the subordinated debt – but couldn’t get a borrow so I shorted the common.It took me about 15 minutes to make that decision.

Here are the things that stood out:

It had specifically disavowed interest rate risk saying that it had shifted its security holdings towards FHLB securities because they could easily be pledged (as they contain little credit risk) and could be purchased with short durations,

It had massively grown its deposit base in deposits greater than 100K by using promotional rates,

After this promotional binge it was the bank most dependent on jumbo deposits that I have ever seen.Given the noise of banks failing the populace could get quite jumpy about jumbo deposits and I would not think that funding base is very secure,

Despite having expensive funding and not taking interest rate risk it had a margin of 4% (now declining) - which suggests it was doing something else to get the margin,

That something was (more or less obviously) accepting credit risk.It had 1.75 times its shareholder equity in home-equity-line-of-credit products, 1.7 times in real estate construction loans and one times its capital in loans secured by vacant property owned by developers.It grew its HELOCs sharply in 2006.In 2006 it also more than doubled its mortgages on unimproved land.

I think there is a fair bet that this regional bank is cactus.I really wanted to short its debt.

But hey – what do I know? The provisions through the income accounts were less than 10 million – and outstanding provisions are about 20.The non-peforming loans are only half Webster Financial – and they think the lending is so good that they expanded loans in every one of these categories during the last quarter.

This of course leads to the real reason I won’t name the bank.I smell a rat.A big, nasty hairy one, but I can’t quite identify what it is.On this blog we don’t want to make it up and want to correct our mistakes – and we will not blurt out quasi-fraud allegations against small regional banks unless of course we have three decent forms of evidence.

The Wells Fargo puzzle

So now I will leave you with a question for which I do not know the answer.How is it possible that Wells Fargo’s margin 450bps?Please – serious answers are gratefully accepted as I do not understand.

This is not unusual in the history of Wells Fargo.There have been several points where their margin was greater than the prime rate.

Wells Fargo’s margin is off-the-scale high by global standards – I once did a global survey and it was the fattest margin major bank in the world.

Prima-facie that is good.High margins allow you to take considerable losses and remain profitable.

But usually have to take some risk to get high margins – and as the calculations above show – it is unlikely to be all interest rate risk.When I did my survey the other super-fat margin financials were subprime credit originators (mostly autos and credit cards).

As I said – I do not fully really understand just why Wells Fargo is quite so profitable.Can someone help?

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.